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How Europe Is Making Its Crisis Worse

It is unfortunate that Greece was the first
eurozone member to go bust, for that country’s
experience has tinted the crisis as one of
“fiscal profligacy.” Although it is true that the
Greek government frittered away public
funds and lied for years about its liabilities,
Portugal, Ireland, Spain, and Italy all kept their
fiscal deficits within prudent ranges before
2008. In fact, their primary balances were, on
average, positive between 2001 and 2007
(Exhibit 1). A more accurate assessment of the
crisis is that it was caused by the combination
of current account imbalances, a fixed
exchange-rate regime, and the absence of
guarantees against sovereign default. But let’s
start from the beginning.

Tracing the Origins of the Crisis
The birth of the euro in 1999 meant that
Germany locked the exchange rate with its
European neighbors. In the following years,
Germany’s productivity, contained growth
of unit labor costs, and a constant exchange
rate created a backdrop that was greatly
favorable to German exporters. The country’s
trade surplus ballooned—at the expense of the
current account balances of today’s troubled
economies in Europe’s periphery (Exhibit 2).

Giving up national currencies also meant
handing over monetary policy to a foreign
entity: the European Central Bank. The
new bank’s only mandate was to maintain price
stability for the eurozone as a whole. The
interest rates set to achieve that goal, it turns
out, were too low for the less-competitive
members of the Economic and Monetary
Union. Those countries, faced with low interest
rates and stiff competition in the tradable-goods
sector, had two choices: allow a spurt of
debt-fueled spending and real estate development
(which Ireland and Spain did) or see
their private sectors wither (which Italy and
Portugal did). Either way, the ratio of external
debt/GDP crept up (Exhibit 3).

Fast-forward to 2008. A financial-crisis-cum-deep-
recession engulfed the world. Credit
dried up, unemployment soared, tax receipts
shrunk, and the welfare bill got heavier.
Spain and Ireland had to prop their banks as
well. Germany and the other competitive
countries sprung back to life in 2010. Their
peripheral partners were not as successful, and
their public finances deteriorated quickly.

To be sure, inefficient regional economies and
low interest rates by themselves would
not have produced a sovereign debt crisis. Two
additional prongs are needed to explain how
things got so bad: the mispricing of sovereign
risk and bank regulation (or lack thereof).

After the introduction of the euro and up until
2007, investors assumed that Europe’s financial
integration meant that all of the union’s
government bonds were risk-free (Exhibit 4).
They should have known better. European
Union treaties explicitly forbade bailouts of
sovereigns. Plus, the union’s fiscal rules
quickly proved to be meaningless: In the early
2000s, several countries violated the 3% deficit
limits and got no punishment for it.

Banks, of all investors, should have been forced
to be more prudent. The ECB bears part of the
blame, by discouraging financial institutions
from distinguishing between sovereign bonds
of different countries and initially accepting all
EMU debt as collateral of identical quality.
The European Banking Authority did not include
sovereign haircuts in the stress tests up
until 2010. Before the crisis, a stronger
regulator would have forced banks to shore up
more capital, in a market environment where
it was still possible to do so. Once in the crisis,
marking-to-market just feeds the bank run.

Current Situation and Solutions
Because fiscal deficit is the (mis)diagnosed
disease, austerity is assumed to be the cure.
The European Commission, the IMF, and
the ECB—better known as “the troika”—have
demanded drastic reductions in public deficits
from the countries that have received bailouts:
Greece, Ireland, and Portugal. Spain and
Italy have gone on pre-emptive diets. European
economies, already on shaky footing, are
now certain to suffer deep recessions in 2012.